The New Arthurian Economics

Monday, May 31, 2010

This is how we get into trouble: Redesigning our taxes casually on a Sunday afternoon while reading the newspaper.

Yesterday's Parade magazine does the casual thing with the Value-Added Tax.

Alarmed by our country’s annual $1.4 trillion deficit, some economists have suggested that the U.S. adopt a national sales tax.

See the focus there? ...our country’s annual $1.4 trillion deficit... Economists who are alarmed by one particular part of the economic problem will be unable to see the whole problem, unable to see it clearly, and therefore unable to solve the problem.

Currently, about 150 countries have this type of value-added tax, or VAT: In Great Britain, it’s 17.5%; China, 17%; Mexico, 16%; Egypt, 10%; and Kazakhstan, 12%.

Kazakhstan?

So, just because 150 countries copied each other and got the VAT, that makes it good?

Of the five countries listed by name, which one has a good economy? None. Not even China, at the moment. And before the financial crisis? only China, probably. And if China was doing well it wasn't because of the VAT. It was because China has a young and growing capitalism that is sucking the life out of ours.

Anyway, looking at the VAT as a solution is as myopic as focusing on the deficit when we need to understand the whole problem. And for the record, one does not solve economic problems by adopting casually-considered policies. One creates problems that way.

The tax typically applies to all purchases, as well as to services from haircuts to stock trades.

Oh, well there ya go. But I'm bettin' that's not true. The VAT doesn't apply to all purchases. It applies to all consumption only, and not to the "supply side." So it further enhances the imbalance between supply and demand.

And whose great idea is it anyway, to tax "value added"? Don't we want to add value? Don't we want to create value?? Don't we want to grow output???

Every tax is a dis-incentive. A tax on value-added discourages adding value. The VAT discourages the growth of output. It it has any positive effect at all, it is that by enhancing the imbalance between supply and demand it makes the supply side look a little better for a while. A few years down the road, we'll be looking for some other thing we can do to fix the economy again.

Just don't be casual about policy, that's all. Economic policy shapes the world.

VATs “often generate half of a country’s public revenues,” says Robert Goulder of Tax Analysts, a nonprofit publisher of tax-policy magazines. In France, for instance, the VAT accounts for 52% of the money the government collects. “Most of the 150 countries that have a VAT would be fiscally crippled without it,” Goulder says.

Geek. Most of the countries that don't have the VAT would be financially crippled if you removed their biggest source of revenue. This isn't logical argument. It's filler for the Sunday paper. Casual crap.

In the U.S., each 1% of VAT could raise $1 trillion over 10 years, according to the Congressional Budget Office. While some federal lawmakers are warming to the idea, others say such a tax disproportionately hurts the poor, who spend most of their income on necessities. Some countries counter that problem by using a dual-rate structure—lowering or eliminating the VAT on purchases like prescription medicines and groceries. However, some policy experts worry that a VAT could actually raise so much money—and so easily—that it would encourage Congressional waste. “A VAT would take the pressure off the government to rein in spending,” says Rudolph Penner, a fellow with the Urban Institute, a public-policy think tank. “And the more they spend, the more taxpayers have to shell out.”

— Drew Jubera

Blather. Shame on you, Drew Jubera. There's no such thing as a painless tax.

Sunday, May 23, 2010

"...more than 11 million U.S. families currently owe more than their houses are worth."

"...assistance is coming from an unlikely source: Lewis Ranieri, a former Wall Street trader whom many people blame for helping facilitate the mortgage mess."

"Ranieri is attempting to repair some of the damage caused by the misuse of the mortgage-backed securities market he pioneered while head of the mortgage desk at Salomon Brothers in the 1980s."

Okay. So do I trust this guy or not? Two paragraphs in, this is my question. Maybe it's another scam, another con, another Madoff-with-the-money. What do I think of this Lewis Ranieri? I read the rest of the article looking for an answer.

Ranieri's new company buys "distressed mortgages, often at discounts of 40% to 50%." It works to improve the homeowners finances and the mortgage terms. And it sells the mortgages at a profit.

Okay. Oh, I don't have a problem with a guy making a profit. In turbulent times, money moves in strange ways. And any time money moves, there's a chance to make a profit. So Lewis here could be doing really good things, good for homeowners, good for the economy, and still make a profit doing it. Could be. This doesn't bother me at all. But I still don't know what the guy is up to.

"The only way to really help people is to reduce the principal balance of the loan and the total amount they owe," Ranieri declares. "The government is just forestalling the problem by reducing monthly payments."

Okay. I like the guy. Go to him for help? Can't say. But I like him. I like what he says about debt. We have to reduce debt. He's right. I say the same thing.

A lot of people say the economy won't recover until we reduce debt. They're right.

The difficulty (as Keynes said) isn't in the new ideas, but in escaping from the old ones.

We have to stop debt from accumulating, or the economy will stop it for us. That's what the financial crisis was -- the economy's attempt to fix the debt problem. We're lucky it didn't work. But the economy will try again, unless we take care of it with policy.

Jerry continues:Maybe it has to do with "the cost of money" rather than the "amount of money"? something like "cost-push inflation" - but i don't know what that is. The only way that inflation makes sense to me is if it's the ratio of "dollar bills" to "value" (loaves of bread or something). If there are 100 dollars per loaf of bread, then bread is probably going to cost 100x more than if there is 1 dollar per loaf of bread. What is the explanation the other kind of inflation?

The world is so fully committed to Milton Friedman's "quantity theory" of inflation, that my mind is not able to comprehend any other explanation. For example the last sentence in this excerpt --

Also, my personal favorite money multiplier analogy starts with the observation that a checking account dollar is actually a call option on a green paper dollar, with a strike of zero and no expiration. Option pricing theory says that the issue of options does not systematically reduce the value of the base security, since options do not affect the assets and liabilities of the issuer of the base security. In the same way, the quantity of checking account dollars does not affect the value of green paper dollars, since the Fed's assets and liabilities are unaffected by the actions of private banks.

-- from Mike Sproul's comment (the 3rd comment to the 17 April post) on Williamson's new monetarism blog. I just can't get my head around it.

But that's okay, as the quantity theory makes good sense to me. It makes sense at least two ways:

1. A change in the quantity of money can induce a change in total spending, and it is spending that affects the level of prices.

2. The more there is of something, the less valuable we find it, even... if it's... money.

But wow, it was hard to write those last four words. I must say, I don't know anyone who is willing to support the dollar by refusing a bonus or a raise or a windfall. So, maybe there's only one way the quantity theory makes sense to me.

Good enough. I buy it. Still, there are other parts of Friedman's argument that give me trouble. In Money Mischief he writes:

"The initial side effects of a slower rate of monetary growth are painful: lower economic growth and temporarily higher unemployment without, for a time, much reduction in inflation. The benefits begin to appear only after one or two years or so, in the form of lower inflation, a healthier economy, the potential for rapid noninflationary growth.. The 1980s provide a clear example of this sequence."

"The side effects of a cure for inflation are painful... The basic reason why the side effects occur is because variable rates of monetary growth introduce "static" into the information transmitted by the price system."

Static? Sometimes Friedman's arguments are less rigorous than they ought to be.

I don't dispute the quantity theory. I take it as a "given." But suppose something weird happened...

Suppose it came about that we needed, oh, less than 2% annual money growth to keep inflation acceptably low, but for some reason we also needed more than 4% money growth to keep the economy growing at a satisfactory rate. This would be a problem.

Not would be, as I see it. This is a problem, a problem of long standing, standing since the days of LBJ and Nixon. But lets just suppose it's a problem, and see where that takes us.

It takes us to a familiar haunt: We cannot get growth enough to keep unemployment low. We can't get growth enough to balance the budget. We can't get growth enough to keep living standards climbing. We can't get growth enough, period. But still we have inflation -- too much inflation, for too many years.

And we cannot solve the problem.

Let's say the only thing that causes inflation is too much money, whether by printing or borrowing. Too much money, Jerry: your "ratio of 'dollar bills' to 'value.'" And we know it to be true. But every time we cut money growth to stabilize prices, we create a recession. And Friedman was wrong: We never get the "rapid noninflationary growth" he promised. We never get the Golden Age.

The problem isn't "static" generated by messing with the money supply. The problem is that we need an inflationary rate of money growth in order to get the economy to grow at all. In other words: There is a problem on the growth side, a problem that demands more inflation that we find acceptable.

The growth-side problem is rising cost. Rising cost inhibits growth. And it turns out that creating some inflation compensates for rising cost and gets us a little growth.

The "compromise" solution has been to settle for more inflation and less growth than we want. This inflation is created by "too much money" as you understand it Jerry, but it is driven by a cost problem. That's how we get cost-push inflation. Because without the inflation, we just don't get the growth.

The only other known solution is to restrict money more, and fight inflation better, and lie to ourselves about the growth that never comes.

The correct solution -- the Arthurian solution -- is to admit that the problem is a cost problem on the growth side, recognize that excessive reliance on credit is the source of the cost problem, and solve the problem by reducing our reliance on credit. The correct solution is not compromise. It is victory.

Jerry continues:If the interest rates were the CAUSE and the inflation the EFFECT, I would think that the inflation would lag a bit behind the rate changes, right? Looking at it, I think the opposite is happening - the blue line peaks or bottoms out first.

Oh yes, existing policy fights inflation by raising interest rates. So we should expect to see inflation lead and interest rates lag, if and when they show a similar pattern. But for the early post-war years they don't show a similar pattern at all. Then again in the later post-war years, the similarity is obvious! Clearly, there was a change somewhere along the way.

The increasing reliance on credit was the cause of that change. And the similarity of interest rates and inflation, regardless of lead/lag, is one result of the change.

Note that if the Federal Reserve anticipates inflation and responds proactively to prevent it, interest rates may lead and inflation lag. Just the opposite of your supposition.

It strikes me that an alternative explanation for that second chart could be the "Taylor rule". Part of the "rule" was that your interest rates should go up if inflation is going up. So if the Fed were using that rule to set interest rates, you would expect that the purple line would follow the blue, since they are watching the blue line and basically trying to match it. It wouldn't be exactly right, since there are other terms in the rule (GDP growth). But there would be some correlation.

Jerry, you are the only person I know who could take that formula and work backwards to understand what it says about economic policy.

Jerry writes:I think what you are saying is that the money supply is mostly controlled by lending, and so inflation is mostly controlled by lending.

If that were true, wouldn't you expect that the periods of low interest rates would spur MORE borrowing, and there would be MORE inflation? that is, isn't the graph sort of upside-down from where it should be? they shouldn't be a glove-like-fit, but rather a mirror-like-reflection.

Well yes, Jer -- Low interest rates DO spur more borrowing, leading to more inflation. But it's not instantaneous, so my graph doesn't show a "mirror-like reflection."

There is a lag between when rates start to fall and when borrowing begins to increase. That interval of time is when recession occurs. If your "mirror" idea was correct, there would be no recession.

The glove-like fit on my graph above comes from interest rates and inflation moving up together in the "good" years, and down together in the "bad" years. The mirror-like movements occur near peaks and troughs of the cycle, where interest rates continue to rise while inflation begins to fall, or the reverse.

The mirror-like movements occur fleetingly and only at particular points of the business cycle.

Recession, Growth, Interest Rates, and Time Lags

Interest rates rise during the good years, reach a peak, and fall through the bad years. This graph from the St. Louis Fed shows the pattern.

As you can see on this graph, interest rates generally don't "break" and start to fall until growth is giving way to recession. And once recession starts, it feeds on itself. So there's less borrowing and less growth and less inflation even while interest rates are falling. Glove-like.

After a time confidence returns, low interest rates spur more borrowing (as you say), the recession ends, and economic growth resumes. But again, it is not instantaneous. Coming out of recession, borrowing begins to increase only gradually. This subtle change in borrowing will lead to a rise in interest rates, but not until the growth of credit-use regains momentum.

As the economy grows, demand picks up more and more. Increasing demand for loans begins to pull interest rates up. Increasing demand for goods and services leads to increasing inflation. Then we see more borrowing and more growth even while interest rates are rising. Interest rates and inflation move up together, glove-like, until a sudden drop in borrowing allows interest rates to break again.

So Jerry, your critique of my graph is correct except you overlook the time lags. Low interest rates do spur borrowing, but only when people are ready.

A Larger View

The St. Louis Fed graph clearly shows interest rates responding to the business cycle. Like a heart monitor in ICU, a canary in a coal mine, interest rates provide significant feedback.

But underlying the vigorous up-and-down pattern of that graph is a carrier wave, a long-term trend that shows increase from the mid-'50s to around 1980, and then decrease. This is a different kind of business cycle, a much longer cycle, perhaps a Kondratieff wave.

The Kondratieff is a business cycle fifty years or more in length. Wikipedia points out that "Kondratieff ... made observations focusing ... on prices, inflation and interest rates." Prices, inflation and interest rates. We have the same focus.
Oh, and speaking of big cycles... Have a gander at some of the charts in Sidney Homer & Richard Sylla's A History of Interest Rates. Scans from my copy:

Chart 1 provided a very rough sketch of the trends of minimum ancient Greek and Roman interest rates... A saucer-shaped pattern was followed by interest rates during the history of each ancient civilization... Chart 78, which is based on long-term interest rates in those nations forming what is often called Western civilization, reveals what could be the first part of a similar saucer.

Arnold Toynbee showed that civilizations rise and fall in a recognizable pattern. Homer and Sylla show that interest rates are intimately involved in the process. And Keynes identified the interest-rate trough in the cycle of civilization as "the greatest age of the inducement to invest." He called it "a limiting point" ... "a period of almost one hundred and fifty years."

Are we late in the saucer-shaped pattern? Are interest rates on the rise in our era? I would say yes, and yes; but I don't make predictions. Still, there is an urgency to this matter that demands our attention.

All these business cycles, of various duration, are based on, or exposed by, or closely related to the pattern of interest rates. No, I don' think we could solve our problems by passing a law to limit the rate of interest. But interest rates are the canary in the coal mine of civilization. They are an early-warning system we must not ignore.

Money becomes credit by an act of lending. Credit becomes money by an act of spending.

Money is put into circulation by the Federal Reserve. Credit is put into circulation by anyone who borrows money.

Money is removed from circulation by Fed policy decisions. Credit can only be removed from circulation by the repayment of debt.

Oh, and we can use money to pay off debt. But we cannot use credit to pay off debt.

There are many differences between money and credit. Most important of them all is that credit-use carries costs that money does not: the cost of interest, and the repayment of principal. A dollar you earn and spend is gone and soon forgotten. A dollar you borrow and spend may be gone, but if you forget about it the bank will send a reminder -- and you'll pay for your forgetfulness.

My two graphs in the previous post show a change in our economy: a decline in the reliance on money, and an increase in the use of credit as money. Our medium of exchange has become more costly. Costs throughout the economy are greater, because of the increased cost of the medium of exchange.

Previously (25 April 2010: The Policies of the Venn Overlap) I noted a change in our economy from "money in circulation" to "credit in circulation." To my way of thinking, this change is the source of our economic troubles. So I was happy to see Jerry's comment that the post reminded him of two graphs I'd done for my "12 pages" PDF.

But in private correspondence Jerry had second thoughts about the value of those graphs. He writes:Now I'm wondering, though, looking at the graphs again. The money supply graph I think makes a lot of sense. And shows that the correlation falls off later on. That supports your argument 100%.

Jerry's first remarks refer to my "Prices and the Money Supply" graph.

The graph shows inflationary peaks rising and falling under a canopy set by the quantity of M1 money relative to GDP, until 1960 or so. After that, as Jerry says, "the correlation falls off."

My point exactly.

So far, so good. Then Jerry drops the other shoe:The other (interest rates) graph makes less sense to me. Something is certainly going on there, but it's not clear to me that what's going on is what you are saying is going on.

His comment here refers to my "Prices and the Rate of Interest" graph.

In this graph you can see that the sharp ups and downs of inflation in the 1920-1960 period show little similarity to the tame, flat trend of interest rates during that era. But after 1960 the two trend-lines show a lot of similarity: Just the opposite of the "Money and Prices" graph. The periods of similarity occur at different times.

The two graphs together show a transition. They show consequences of the change in our economy from a reliance on money before 1960, to a reliance on credit since that time. My graphs show that inflation used to be closely related to money issued by the Federal Reserve, and that this is true no longer.

Yeah, maybe the graph seems to suggest that the rate of inflation is tied to the rate of interest. But I'm not saying that. I'm saying only that the use of money-that-costs-interest is different and more costly than the use of money that doesn't.